Fixed Incomebeginner

Money Market and Capital Market

The money market trades short-term debt that matures in one year or less, while the capital market trades long-term debt and equity. Governments fund themselves across this spectrum with Treasury bills (one year or less, sold at a discount with no coupon), Treasury notes (two to ten years, coupon-bearing), and Treasury bonds (beyond ten years, coupon-bearing). Money-market funds pool investor cash into these short instruments to offer high liquidity and low risk. Money-market yields are often stated on a bank discount basis, a convention that understates the true return because it divides by face value and uses a 360-day year.

Why it matters

Think of two parking lots for capital. The money market is the short-stay lot where cash idles safely for weeks or months and you can leave almost instantly. The capital market is the long-stay lot where money commits for years in exchange for a higher yield. A T-bill is the purest short-stay ticket. You pay less than face today and collect the full face at maturity, and the gap is your interest. The discount-yield convention makes that gap look smaller than the return your money actually earned.

Formulas

Bank discount yield

r_{\mathrm{BD}} = \frac{F - P}{F}\times \frac{360}{n}

Here

F

is face value,

P

is price, and

n

is days to maturity. Dividing the dollar discount by face value (not price) and using a 360-day year both pull the quoted figure below the true return.

Bond-equivalent yield of a T-bill

r_{\mathrm{BEY}} = \frac{F - P}{P}\times \frac{365}{n}

The bond-equivalent yield divides the gain by the price actually paid and uses a 365-day year, so it always exceeds the bank discount yield for the same bill.

Worked examples

Scenario

A 90-day Treasury bill with face value A$100,000 sells for A$99,000. Find its bank discount yield and its bond-equivalent yield.

Solution

The dollar discount is $F-P=1000$ . Bank discount yield is $\tfrac{1000}{100000}\times\tfrac{360}{90}=0.04$ , or four percent. Bond-equivalent yield is $\tfrac{1000}{99000}\times\tfrac{365}{90}=0.0410$ , about 4.10 percent. The bond-equivalent figure is higher because it divides by the smaller price paid and uses a full year.

NoteAlways compare instruments on the same yield convention. A bill quoted on a discount basis looks cheaper to hold than it truly is.

Common mistakes

✗Treasury bills pay a coupon like notes and bonds. T-bills carry no coupon at all. They are sold below face value and the entire return comes from the price rising to face at maturity.
✗The bank discount yield is the real rate of return on a bill. It is only a quoting convention. It divides by face value rather than price and assumes a 360-day year, so it sits below the true holding return.
✗Money-market funds are insured and cannot lose value. They aim to hold a stable value but are not government-guaranteed deposits. In stress a fund can "break the buck" and fall below par.
✗Longer maturity always means higher credit risk. Maturity drives interest-rate and liquidity risk. A long Treasury bond still carries the same sovereign credit standing as a short Treasury bill.

Revision bullets

•Money market: debt maturing in one year or less, high liquidity
•Capital market: long-term debt and equity
•T-bills are zero-coupon and sold at a discount; notes and bonds pay coupons
•Bank discount yield divides by face value and uses a 360-day year
•Bond-equivalent yield divides by price and uses 365 days, so it is higher
•Money-market funds pool cash into short instruments for liquidity, not a guarantee

Quick check

Why does a Treasury bill have no coupon payment?

For a given Treasury bill, how does the bond-equivalent yield compare with the bank discount yield?

Connected topics

Fund Types Market Structure Bond Basics Bond Yield Yield Curve

Sources

Brailsford, Heaney & Bilson (2015), Ch. on debt securities
Brailsford, T., Heaney, R., & Bilson, C. Investments: Concepts and Applications. 5th ed. Cengage Learning Australia, 2015.
Covers money-market versus capital-market instruments and the structure of government debt.
Bodie, Kane & Marcus (2021), Ch. 2
Bodie, Z., Kane, A., & Marcus, A. J. Investments. 12th ed. McGraw-Hill Education, 2021.
Details Treasury bills, the bank discount yield, and the bond-equivalent yield convention.

How to cite this page

Dr. Phil's Quant Lab. (2026). Money Market and Capital Market. Derivatives Atlas. https://phucnguyenvan.com/concept/im-money-market

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